Ranjit Dighe
Lecture notes to accompany Mishkin's Chapter 7 ("The Stock Market, the Theory of Rational Expectations, and the Efficient Market Hypothesis")

In these notes:
I. The valuation of stocks

II. The efficient-market theory of the stock market

Although the stock market is not central to either money or banking, it nevertheless occupies an important place in this course. In applications of the Theory of Asset Demand, stocks are prominent, in part because they have the highest average return (about 10%) of any class of assets. The concept of present discounted value (PDV) is often used in pricing stocks. And in the next chapter, on the economic analysis of financial structure, we'll learn why issuing new stock is so rarely used by companies as a means of finance.


Stock prices are widely watched and change by the minute. Prices are set through the interactions among the many traders on the various stock exchanges. Because the stock market has a huge number of traders, each one too small relative to the market to influence the price, we can say that the stock market is a competitive market, and stock prices are determined by supply and demand. Traders buy and sell securities based on their estimated valuations of them. But where do those estimated valuations come from?

The simple answer is that stocks are valued as the PDV of future dividends. (Dividends are shares of a company's profits, set in advance as a certain dollar amount per share.) Some guesswork is involved here, as we don't know how much those dividends will be in the future or even when (or if) they'll be paid. Many thriving companies, especially younger ones, do not pay dividends at all. Is a company's stock worthless if the company never pays dividends? Doubtful.
-- Some analysts prefer this alternative: stocks are valued as the PDV of future earnings (profits) per share. Stocks are shares of ownership in a company, after all, and owners can enjoy profits whether they pocket them (in the form of dividends) or not. This approach, like any approach to stock valuation, also involves much guesswork, since a company's future earnings are never known in advance, so projections may be way off.

Using the standard PDV formulas to price stocks is fairly straightforward. The easiest case by far is when the company pays a dividend and is expected to pay that same dividend forever. (This may be a reasonable expectation for a very stable company, like a utility company.) In such cases, the appropriate PDV formula is the consol-bond formula, since a share of stock that pays the same yearly dividend forever is just like a bond that makes the same yearly payment ($FP) forever. For a given interest rate, the PDV of a constant-dividend stock or a consol bond is


To repeat an earlier example: Suppose Minnesota Power stock pays a $2 dividend that is expected to continue forever, and the interest rate is 5%.
--Q: What should the stock's price be?
--A : $2/.05 = $40.

Other cases are more complex, and different models have been developed to price stocks in those situations. Among them are these:
-- The one-period valuation model (price should be the PDV of dividends in the first year, plus the expected resale price of the stock at the end of the year).
-- The generalized dividend valuation model (same, but for any number of years).
-- The Gordon growth model: price should be the PDV of the future stream of dividends, which are assumed to grow at a constant rate forever.

Whichever model one uses to estimate appropriate valuations of stocks, those estimates will tend to be volatile, because they will change whenever the interest rate (i, part of the denominator in every PDV term) changes or as new information that would affect future dividends or earnings becomes available. Small changes in interest rates or estimated profit growth can mean large changes in stock valuations, and hence prices. Even day to day, then, the stock market is often volatile.


The efficient-market hypothesis (or theory) says the stock market as a whole does the best job possible in valuing and pricing stocks. The market acts rationally, says the theory, using all available, relevant information and leaving no profit opportunity unexploited. This would imply that strategic stock picking is pointless, because the market has already priced every stock appropriately, given the current information.

The efficient-market theory is an application of a theory that has been extremely influential in macroeconomics over the past thirty years, namely--

The theory of rational expectations: Expectations will be identical to optimal forecasts (the best guess of the future) using all available information.
--Example: Your expectations of today's weather (which inform your choice of what to wear, etc.) are not rational if they're based on the guess that today's weather will be like yesterday's, or a hasty look outside. Rational expectations of the weather would involve listening to or reading a top-quality forecast by a professional meteorologist.
---- (If you didn't have time to listen to the weather on the radio this morning, it might have been a rational decision, if you had something better to do, but you will not have rational expectations of the weather. This goes to a key reason why people do not always have rational expectations - obtaining all the relevant, available information can be costly or inconvenient.)

In financial markets, people want to get rich, so they should follow all the relevant economic and financial series, read the company reports, and do whatever else is necessary to maximize one's (risk-adjusted) returns in the market. If enough traders in the stock market do this, then every stock's price will be rationally determined, and the prices of stronger stocks will be bid up and the prices of weaker stocks bid down, to the point where the expected return on every stock will be the same! At that point, a person looking for stocks to buy need not do any research of his own; he can just free ride on the wisdom of the other traders. In fact, he might as well make his picks by throwing darts at the newspaper stock listings...

News flash (a true story):
A Swedish newspaper gave $1,250 each to five stock analysts and a chimpanzee named Ola, to test who could make the most money on the market in a one-month period. Ola the chimp, who made his choice of purchases by throwing darts at the names of companies listed on the Stockholm exchange, won the competition.

A fluke? Maybe, maybe not.
-- For years, the Wall Street Journal did this every month, enlisting four Wall Street stock experts to pick one stock apiece, and then having someone throw darts four times at the paper's stock listings. After six months they'd compare the average returns on the four stocks the experts picked versus the four stocks the darts hit. Very often, the "dartboard portfolio" won; almost always it beat at least one or two of the pros' picks.

These kinds of studies are often conducted and reviewed by economists, too. Mishkin's textbook has a section on them, titled, "Should you hire an ape as your investment adviser?" Or maybe you don't need an investment adviser...

The EFFICIENT-MARKET THEORY OF THE STOCK MARKET:  Stock prices reflect all available, relevant information.  When it comes to prices, the stock market is efficient in that "you get what you pay for" -- stock prices of the companies with the best prospects will be bid up to high levels, and stock prices of companies with weak prospects will be bid down to low levels.  Because the return on a stock is inversely related to what one pays for it, the returns on different companies will tend to be the same.  Corollaries:
-- You can't outguess the market.
-- Systematically "beating the market" (outperforming the market averages) is practically impossible.

According to the efficient-market theory, you'd be best advised to follow a PASSIVE INVESTMENT STRATEGY: Switch to index funds (mutual funds that simply track a stock-market average, rather than being actively managed), and hold them over a very long time period (a buy-and-hold, not buy-and-sell, strategy).

Q: Is the efficient-market theory of the stock market just a silly theory?
A: NO! It's supported by hundreds of empirical studies.  (Caveat:  some other studies go against it.  More on them later.)
-- FACT: The S&P 500 index outperformed over 2/3 of professionally managed portfolios for the decades of 1970s, 1980s, and 1990s. In nine of 13 years (1984-96), the S&P 500 index outperformed the majority of mutual funds. Over the 1990s, the S&P index has had a total return of 312 percent -- one-fourth greater than the average domestic stock fund.
---- Notably, the indexes have outperformed the managed portfolios both when the market was doing poorly (the '70s) and when the market was doing great (the '80s and '90s.)

Q: Why do most mutual funds do so badly relative to the market? They're run by smart people, aren't they?
(1) Capital gains taxes -- when a mutual fund sells stock at a profit, it gets taxed on those gains; if you buy stock and just hold it as its price appreciates, you don't pay taxes.
(2) Transactions costs -- Buying and selling stocks means incurring brokerage or trading fees. Buying and holding stocks does not involve any transactions costs.
(3) Over-managing, due to perverse incentives? -- pressures for short-term successes and to "look busy" in order to justify their fees. Also, since every managed fund wants to "beat the market," they often try to time the market -- i.e., be in when the market's soaring, be out when it's stagnant or hurting -- and it's much easier to lose money than to make money that way. Peter Lynch: "Far more money has been lost by investors preparing for corrections than has been lost in the corrections themselves."

What most of the mutual-fund houses have to say about index funds:
(1) They're un-American. Trying to "beat the market" is the "American dream." (Huh?)
(2) They point to the success of the funds that did beat the market.

[At about this point in the lecture I conducted the Eco 340 coin-tossing competition. It was inspired by a metaphor that efficient-market-theorist Burton Malkiel proposed for the following metaphor for the great mutual-fund success stories:]
-- Imagine a coin-tossing contest with 1000 people. "The contest begins, and [they all] flip coins. Just as would be expected by chance, 500 of them flip heads, and these winners advance to the second stage of the contest and flip again. As might be expected, 250 flip heads. Operating under the laws of chance, there will be 125 winners in the third round, 62 in the 4th, 31 in the 5th, 16 in the 6th, and 8 in the 7th.
-- By this time, crowds start to gather to witness the surprising ability of these expert coin tossers. The winners are overwhelmed with adulation. They are celebrated as geniuses in the art of coin tossing -- their biographies are written, and people urgently seek their advice. After all, there were 1,000 contestants, and only eight could consistently flip heads."
----> POINT/ANALOGY: The big stock-market success stories are perfectly consistent with the laws of chance.
Are today's mutual fund managers who beat the market several years in a row geniuses, or just lucky?  Given the thousands of mutual funds out there, luck surely explains many, if not all, of those success stories.

Moreover, even the most successful ones always issue the disclaimer, "Past performance is no guarantee of future performance." In fact, empirical tests of the efficient-market hypothesis typically find the top-ranked funds from one period generally earn only average returns in the next period. So market-beating funds have a tendency to fall to earth.

One objection:  Just because the repeated success of a (very) few individuals is consistent with the laws of chance doesn't mean it's explained by the laws of chance. Coincidence ain't causality. Talent might plausibly be the explanation, too; and it virtually has to be the explanation for such giants as Peter Lynch (Wall Street legend who ran Fidelity's Magellan Fund for the 20-plus years that it did beat the market and everybody else) and Warren Buffett, who still runs Berkshire Hathaway.
-- On the other hand, Peter Lynch has retired (at age 47!) from active fund management, as have many of the other giants of the 1980s; and Berkshire Hathaway is a closed-end fund whose shares tend to sell for a big markup over their Net Asset Value (and they are priced so that a single share costs tens of thousands of dollars!).

Evidence in favor of the efficient market hypothesis:  A summing up:

Evidence against the efficient-market hypothesis

Although hundreds of empirical studies have been supportive of the efficient-market theory, most were largely conducted fairly early in the life of the theory (1970s, 1980s, early 1990s). More recent studies have been somewhat less favorable.  The recent studies do not prove that the stock market is usually inefficient, but they do reveal several anomalies in stock-price behavior that seem inconsistent with the efficient-market theory:
Taking stock of the efficient-market hypothesis

Clearly this evidence is mixed and the studies are controversial, but the efficient-market theory still seems "a good starting point" for understanding stock prices. At heart, the theory isn't too different from the PDV-based approaches to valuing stocks at the beginning of this unit. But there are too many exceptions, most notably the market's excessive volatility, to make the efficient-market theory the last word in understanding stock prices. Perhaps the stock investors with rational expectations don't control enough shares to drive all stock prices to their appropriate levels?
-- (Of note: For the bond market, the efficient-market theory looks very convincing.  There's much less uncertainty in the bond market than in the stock market.)

The impact of the efficient-market view is also mixed, but has been on the rise since at least the early 1990s. The tech boom and bust may have derailed it a bit, but index funds are still very popular.  Clearly the investing public has gradually become fond of index funds:  Vanguard's S&P-500 index fund became the country's second-largest mututal fund in the late 1990s.  The largest mutual fund company (Fidelity) introduced several index funds in the 1990s, in order to keep up with the competition, and numerous other mutual-fund houses introduced index funds of their own. 

Application: Practical guide to investing in the stock market
-- How valuable are published reports by investment advisers? Not.
-- Should you be skeptical of hot tips? Yes.
-- In three words, what should a smart investor do?  Buy and hold.
(All three of these strategies follow straight from the efficient-market theory, which is, of course, controversial. But, empirically speaking, all of these particular strategies tend to work.)